CHART OF THE DAY: Here's What The Changing Stocks-Bonds Correlation Means For Equities When The Fed Tapers

The chart below shows how the correlation between U.S. Treasury
yields and the Dow Jones Industrial Average has varied under each
iteration of the quantitative easing program of bond purchases
the Federal Reserve has employed since the financial crisis.

Under QE3 (the current iteration), changes in bond yields have
have been associated with larger changes in equity prices than
under any other program. So, when yields rise, so do equities,
and when yields fall, so do equities — in both directions moreso
than in the past.

The red square near the top of the chart plots the current levels
of the yield on the 10-year Treasury note and the DJIA. Its place
above the regression line shows that equities are looking rich
based on this relationship.

Société Générale fixed income strategists believe the regression
line is actually too steep.

In other words, when yields rise again (induced by a tapering of
QE) as they did earlier this summer, the strategists believe the
relationship charted by the regression line will break down as
higher yields fail to boost equity prices.

"We have currentlyreached a new peak in
equities, and the 'beta' — that is,the strength of the relationship for equity prices to rise
as bond yields rise(the coefficient on 'x' in
theregression equation)
—is probably unsustainably
highas the Fed tapers asset purchases over the next
six months," write the SocGen strategists in a note to
clients.

"Based on the QE3 regression equation, the projected level
ofthe Dow for a 10-year Treasury yield at 3.00% is
15,916; for 3.25% it’s 16,338;and for a 10-year
Treasury yield at 3.50%, the Dow would be at 16,760, or 5% higher
than it is right now.We don’t expectequity prices to dive, but we do suspect that in
2014as the Fed eventually tapers asset purchases,
the level of bond yields will rise and equity prices will be
volatile, moving roughly sidewaysfor a time while
both markets re-adjust."

"The biggest risk to our thesis, in our view, remains the
potential for a negative monetary policy surprise (more likely in
the U.S. than Europe)," he says. "That is, we believe equities
remain uncomfortable with the notion of asset tapering without
the economy at perceived escape velocity."